With the Federal Reserve (Fed) about to lose its patience for a zero interest rate policy and the market possibly largely unprepared for this shift, it is important for investors to develop a plan for their portfolios when interest rates inevitably rise. In our view, zero and negative duration strategies provide notable alternatives that portfolio managers should consider as a way to refine a portfolio’s sensitivity to changes in interest rates.

In previous tightening cycles, many investors have reduced their interest rate risk by:

1) increasing allocations to cash;
2) investing in shorter-maturity securities; or
3) swapping fixed rate coupon bonds for floating rate notes.

However, we find the current market environment particularly problematic, given that interest rates are starting to rise from some of the lowest levels in history. Cash currently entails a very large yield sacrifice. Short-maturity securities usually involve less yield sacrifice but are typically at maturities that are very sensitive to changes in Fed policy. Floating rate securities can offer tradeoffs somewhere between the two other options, but these will likely depend nearly exclusively on changes in short-term rates. However, the biggest issue we see with these approaches is that they all represent a dramatic shift from the traditional composition and exposure of the starting portfolio.

As an alternative, institutional portfolio managers often source the liquidity of the U.S. Treasury futures market to adjust the interest rate exposure of their portfolios. With many advisors facing operational obstacles in using Treasury futures across their accounts, exchange-traded funds (ETFs) employing zero and negative duration strategies can enable these investors to pursue similar objectives and exposures. Through our collaboration with Barclays and Bank of America Merrill Lynch, WisdomTree has packaged zero1 and negative2 duration strategies on common core fixed-income strategies that maintain exposure to traditional holdings but seek to hedge interest rate risk. In figure 1, we show the impact of blending exposures to the Barclays U.S. Aggregate Bond Index (Agg) and the Barclays Rate Hedged U.S. Aggregate Index, Zero Duration.

Figure 1: Barclays Agg: A Blended Approach to Interest Rate Risk Management
Core Bond Portfolio Blends: Yield to Worst vs. Duration

For definitions of terms in the chart, visit our glossary.

As the chart shows, blending a 20% position in a zero duration strategy into a traditional long-only portfolio3 would result in a portfolio with similar characteristics but a 20% reduction in sensitivity to changes in interest rates. This comes at a cost of approximately 26 basis points (bps) per year.4 Investors can think about the zero duration and long-only strategies as a continuum. On one side, there is full interest rate risk and income potential. On the other side, zero duration, but reduced income potential due to the costs of hedging. However, since the strategy hedges its exposure via U.S. Treasury futures, the income earned on the long bond portion of the portfolio can be distributed as income. The cost of the hedge drips out of the market value of the strategy. Hypothetically, if interest rates stay static over the course of the year, the hedged strategy would underperform the unhedged strategy by the cost of the hedge. Conversely, if interest rates rise, the value of the hedge could help offset losses from the long bond portfolio. For an advisor concerned about rising rates, this blended approach could provide increased flexibility in managing risk versus reward across a portfolio.

Changes in Rates Driving Volatility and Returns

According to Barclays Research, changes in interest rates have accounted for 88% of the overall volatility of the Barclays U.S. Aggregate Index over the last ten years.5 While this volatility ultimately generated positive returns for investors as interest rates fell, what happens when rates begin to rise? To manage a portfolio’s interest rate risk, we believe that negative duration strategies can help investors navigate the upcoming shift in Fed policy. Negative duration strategies will likely have a more significant impact on overall duration, but at a higher cost from hedging via longer-maturity, higher-yielding securities. Additionally, investors may also have greater sensitivity to shifts in the shape of the yield curve, due to the mismatch between the maturity of the holdings and the hedges. In figure 2, we re-create the analysis from figure 1 but blend exposure to the Barclays Rate Hedged U.S. Aggregate Index, Negative Five Duration.

Figure 2: Blending Negative Duration into Traditional Portfolios
Core Bond Portfolio Blends: Yield to Worst vs. Duration